The Basel Committee on Banking Supervision has spoken. In its 'Comprehensive response to the global banking crisis' published on September 7, the committee declared that "the predominant form of Tier 1 capital must be common shares and retained earnings". The message is clear. Hybrid securities are not regarded as high-quality Tier 1 capital.
In policy-making circles, this seems to have been accepted unquestioned as a universal truth. Somehow, hybrid capital was one of the causes of the crisis, a dirty word alongside teaser-rate mortgages and mezzanine CDOs.
But how? The purpose of Tier 1 is to provide banks with a permanent capital base that can absorb losses and assist deleveraging. A brief look at the Merrill Lynch US Preferred Stock Hybrid Securities Index shows the price collapsing from 95 cents on the dollar before the crisis to as low as 35 cents in March 2009. Starting with Deutsche Bank's decision not to exercise the January 2009 call option on its 2014 hybrid, there have been a series of missed calls and coupon cancellations that contributed to the slumping valuations.
And that is how they have done their job, in giving banks the flexibility needed to rebuild capital bases. Of course, in the eyes of the regulators, that may be part of the problem. Hybrid investors who were anticipating bond-like performance will not be prepared to swallow their losses and help banks replenish capital supplies - unlike the equity investors who have digested vast rights issues to maintain their economic interest in the banks.
But even this assumption should no longer be taken for granted. From the second quarter of 2009, many banks have successfully exchanged the depressed older hybrid issues, and often raised fresh Tier 1 at the same time. That Merrill Lynch Preferreds and Hybrids index has rallied almost to pre-crisis levels. The regulatory clampdown may be shutting down a market that is already solving its own problems. In so doing, it risks depriving banks of a vital route for diversifying their investor base, just when they need it most.
